LEGAL CORNER: Important Considerations with Mergers & Acquisitions of Real Estate Brokerage Firms
John Dolgetta, Esq. | October 13, 2021
The real estate industry has certainly been through a lot during the COVID-19 pandemic. At the start of the pandemic, many real estate agents and brokerage firms faced the real concern that the entire real estate market was on the brink of collapse. The panic that had set in quickly subsided and, surprisingly, the real estate market took off in many markets following the initial lockdown orders issued in March in New York and surrounding states. Many left the densely populated urban areas for a more rural setting and employees began working remotely. As a result, the New York City market was hit particularly hard and has lagged in the recovery in comparison to other areas.
As a result of the market conditions, many real estate brokerage firms have effectuated key mergers and acquisitions, and entered into strategic partnerships. The pandemic caused companies to seriously consider consolidation with other firms to solidify established market share or to simply sell their assets to or merge with other companies to firm up operations that were impacted by the pandemic. This article will focus on key aspects to be considered when contemplating a merger or acquisition.
Notable Mergers, Acquisitions and Strategic Partnerships in 2020 and 2021
Some of the notable mergers and acquisitions that occurred during 2020 and 2021 include: (1) Brown Harris Steven merger with Halstead (see https://bit.ly/3iMhKyb), (2) RE/Max Holdings acquisition of RE/Max Integra, (3) Compass acquisition of Bold New York (see https://bit.ly/3oObHgk), (4) Corcoran Group merger with Citi Habitats, (5) Keller Williams NYC merger with two franchises, Tribeca and Midtown (see https://bit.ly/2YICyzy), (6) the acquisition of RentPath by Redfin (see https://bit.ly/3mFMwK5 and https://bit.ly/3DAecXP); and (7) the creation of a new strategic partnership between Howard Hanna Real Estate Services and Rand Realty, to operate as Howard Hanna Rand Realty (see https://bit.ly/3arWbhH). Howard Hanna Rand Realty also announced a partnership with Plawker Real Estate, based in Bergen County, NJ (see https://bit.ly/3at9I8I). In addition, Realogy announced on October 5th that it would be acquiring Warburg Realty, one of the oldest and most prominent residential real estate brokerage firms in New York City (see https://bit.ly/3ar7PcT).
These are just a few of the major transactions announced over the past two years, but many smaller mergers and acquisitions have occurred, and more will surely take place in the coming months and years as the trend toward consolidation grows.
Key Considerations When Contemplating a Merger: Acquisition/Sale or Strategic Partnership
Before contemplating a merger, acquisition/sale or other strategic partnership, brokerages must consider a multitude of issues and should perform extensive due diligence. The National Association of Realtors offers invaluable resources and useful guidance for brokerage firms interested in mergers, acquisitions, and strategic partnerships (see https://bit.ly/3lv3Z8B). It is also important for firms to engage accounting and legal professionals before discussing any potential transaction with another party.
One of the resources cited by NAR is an article published in Forbes entitled “A Comprehensive Guide to Due Diligence Issues in Mergers and Acquisitions” (the “Forbes Guidance”) (see https://bit.ly/3arasuX). The article points out that “before committing to the transaction, the buyer will want to ensure that it knows what it is buying, what obligations it is assuming, the nature and extent of the seller’s contingent liabilities, problematic contracts, litigation risks, intellectual property issues, and much more. This is particularly true in private company acquisitions….” As the Forbes Guidance highlights, conducting extensive and comprehensive due diligence is a critical element of any merger, acquisition or strategic partnership, especially where privately-owned companies (i.e., non-publicly traded companies) are involved. Below are just some of the important items to be considered.
Confidentiality: The Non-Disclosure Agreement
Before a firm commences negotiations or discussions, it is imperative that a mutual confidentiality and non-disclosure agreement be executed by the parties involved. There are many complex provisions, particularly survival, injunctive relief, and other remedy provisions in an NDA that should be reviewed and carefully drafted by legal counsel with experience in contract and mergers and acquisition law. If these provisions are not drafted correctly it could allow for highly sensitive and confidential information to be released and exposed to others in instances where a transaction falls through. No information should be exchanged unless and until the NDA is executed and delivered by all parties involved.
Financial Due Diligence and Contract Review
One of the most important items of due diligence is the review of the financial condition of the companies involved in a particular transaction. It is common for companies to exchange at least three years (more is recommended, if available) of financial data and information. It is strongly recommended that firms review the following financial data: (1) audited, if available, or unaudited, and accountant-prepared, financial statements, (2) corporate, partnership or limited liability company tax returns, (3) profit and loss statements, (4) statements of assets and liabilities and (5) schedules of liens, debts, and other liabilities (contingent and current).
Firms must review all contracts and agreements, including any loan documentation, lease agreements (relating to office space, equipment, vehicles, and other items), agreements with service providers and software providers, and any other agreements, that are to be included in the transaction.
Client and Customer Base: Understanding Business Generation
It is important for companies to review the customer base and list of pending and closed transactions. According to the Forbes Guidance, “the buyer will want to fully understand the seller’s customer base, including the level of concentration of the largest customers as well as the sales in the pipeline.” The Forbes Guidance lists the following topics of concern:
• What customer concentration issues/risks are there?
• Will there be any issues in keeping customers after the acquisition (including issues relating to who the buyer is)?
• How satisfied are the customers with their relationship with the seller? (Customer calls will often be appropriate.)
• What are the sales terms/policies?
• How are salespeople compensated/motivated, and what effect will the transaction have on the financial incentives offered to employees?
Another important consideration includes a review of lead generation policies currently implemented by the seller and/or buyer. It is important to review, for example, exclusive agency agreements with large real estate developers involving new construction projects, and landlord clients for rentals, which will provide invaluable insight into future revenue generation.
Is the Culture a Good Fit?
One major consideration is whether the “organizational cultures” of the respective firms are compatible. The most common concerns that firms have when contemplating a merger, acquisition or partnership are whether the agents will get along and whether the management will remain. According to Gallup, in an article entitled “How to Make Organizational Culture Part of M&A Due Diligence,” most mergers and acquisitions fail because companies “ignore organizational culture” (see https://bit.ly/3mILQUk).
Gallup emphasizes that “deep dives into the cultures of both the acquiring and acquired companies are vital.” Gallup explains that the culture is usually considered to be either “tight” or “loose” and offers a real-life example where cultures clashed. Gallup explained that when Google acquired Nest, the acquisition failed because Google had a “loose” culture and Nest had a “tight” culture. Ultimately, because of this clash in cultures, Nest’s founders quit, and the transaction generated very little profit. In addition to organizational culture, Gallup recommends that companies should also consider the work style of the employees and agents. Gallup recommends that the leaders of each of the firms should carefully consider the two following concepts when negotiating a potential transaction:
“1. Organizational culture, or how the target company ‘does things around there.’ Are norms tightly enforced? Or are they loosely applied?
2. Work style, or how the organization prefers to distribute and complete the work. Do work orders flow down the org chart? Or is autonomy granted—and if so, to whom?”
Gallup explains that “mergers collapse when leaders fail to understand the cultural imperatives of the union of two organizations—or recognize that culture is omnipresent, invisible, complex and multilayered.” Gallup further points out that “…a framework that recognizes culture and work style as two different things and critically examines purpose, strategy, culture, brand and the employee experience—in tandem with other operational and financial measures—gives M&As the best chance of success.”
Considerations Regarding Employees, Key Management Personnel and Key Agents
Other considerations that are closely related to the “culture” issue, are how to deal with announcing a potential transaction to key management personnel, employees, and agents, and to whom a transaction should be disclosed. It is not uncommon for the buyer or seller of a brokerage firm to want to refrain from announcing a potential transaction to agents, employees and/or key personnel until it is ready to close, or sometimes even wait until after the merger or acquisition is completed, due to fear that key personnel will leave.
However, if there are key agents, teams, or key management personnel that the parties deem essential to a transaction, it may be a good idea to have confidential conversations with these key individuals to ensure that they are aware of what is going on so that an effort can be made to have and request that they make a commitment to remain with the company after the transaction is closed. While every circumstance is different, this should be discussed with legal counsel early in the process. All employment and independent contractor agreements should be reviewed carefully. Compensation and commission arrangements are also a critical element to any real estate brokerage merger or acquisition. The parties must carefully consider the potential effects that any changes in compensation structure could have on the success of the transaction.
Agent Licensing Status and Transfer Of Licenses to ‘New’ Brokerage
It is important to review the full license history and complaint history, if any, of all agents transferring to the new company, to ensure that there are no pending or threatened actions or complaints filed with the Department of State or applicable governmental licensing authority, the local Realtor association, or similar entity against any agent. It is also important to include representations and indemnifications in any agreement relating to any such complaints or actions that are not resolved before the closing, or are not revealed, and any threatened or potential claims or issues that may exist.
Additionally, merger and acquisition transactions will require that the licenses be transferred to the “new” entity. In New York, this is usually a very involved process and needs to be coordinated with the appropriate personnel at the New York State Department of State, Division of Licensing. Depending on the number of agents, this can be very costly and should be investigated in advance. Additionally, corporate consents and resolutions need to be prepared by the parties’ counsel and approved in advance by the DOS in connection with the contemplated transaction. Appropriate corporate name change documentation and “doing business as” certificates will be required where the acquired entity will be operating under the acquiring entity’s business name, or vice versa.
Intellectual Property, Branding and Technology Considerations
The Forbes Guidance also points out that the parties should conduct due diligence with respect to technology and intellectual property being transferred in connection a transaction. Some of the items of note include: (1) what trademarks and service marks the company has and whether they are included in the transaction; (2) what, if any, copyrighted works are owned by the firm; (3) potential infringement on intellectual property rights of third parties; (4) pending litigation with respect to intellectual property rights; (5) if there are software or technology rights being included in the transaction; and (6) the IT system currently utilized by the companies and the capacity to support the combined companies. These items, among others, should be reviewed carefully.
Reviewing cybersecurity issues and policies has also become an important aspect of due diligence in mergers and acquisitions transactions. Cybersecurity policies should be reviewed. Firms should request any information on data breaches that may have occurred and how they were addressed. Penalties and fines for not addressing such breaches could be significant. Again, these items must be discussed with legal counsel. Deloitte provides useful insight into conducting and understanding the concept of cybersecurity due diligence (see https://bit.ly/3oW6J1c).
The Structure of Transaction
Another critical element is determining the structure of the transaction. Mergers and acquisitions between larger, publicly-held companies, could include the purchase of the shares of a company or an outright merger of the two companies involved. In this instance, the company purchasing the target firm usually acquires all assets of the target firm as well as takes on responsibility for its liabilities. In many cases, the management team and ownership continue to be employed by the acquiring company.
On the other hand, most acquisitions involving smaller firms are structured as an asset purchase, whereby the purchasing firm only acquires the assets of the selling firm, and either takes on none of its liabilities or takes on only certain specified liabilities (e.g., loans, leases, employment agreements, etc.). Depending on the specific circumstances of the transaction, the acquiring company may purchase the assets directly, or set up a separate corporation or limited liability company to operate the newly acquired company. If there is a franchise involved, approval of the franchisor may be required for any transfer, whether a stock sale, merger or asset acquisition.
In other instances, two firms may decide to set up a strategic partnership, whereby each of the parties contribute specific assets (e.g., specific offices, areas, clientele, etc.) to a newly formed entity. The choice of entity is also a very important factor to consider. Parties may want to form a limited liability company or partnership (see https://bit.ly/3BDzQJW) or a corporation (i.e., C-Corp or S-Corp) (see https://bit.ly/3v6QUWd and https://bit.ly/3FCHTcp). The form of entity and structure of any transaction should be discussed with accounting professionals and legal counsel at the initial stages of any contemplated transaction.
Considering a Sale or Acquisition is a Complex Endeavor
The considerations and issues highlighted in this article are just a few of the many complexities that need to be addressed and investigated before beginning discussions with a potential seller or purchaser. The success of any merger, acquisition, or strategic partnership hinges on many elements, and if parties do contemplate a potential transaction, the more comprehensive the due diligence, the better the chance that a transaction will succeed.